Financial Stability Report - July 2023
The global economic outlook is highly uncertain, and the risk environment is challenging.
Household and business finances
UK household and business finances are under pressure from higher borrowing costs.
UK banks remain strong enough to support households and businesses – even if future economic conditions are worse than we expect.
Non-bank financial institutions continue to need more resilience. We are working internationally to achieve this.
A stable financial system enables households and businesses to make payments, manage their savings, borrow money, and guard against risks. It can withstand shocks rather than make them worse.
The FPC identifies vulnerabilities and acts to build the resilience of the system.
In recent months, interest rates have continued to increase as central banks around the world act to tackle inflation. Since December 2021, the Bank of England interest rate (Bank Rate) has increased from 0.1% to 5%. Returning inflation sustainably to the 2% target will support the FPC’s objective of protecting and enhancing UK financial stability.
Higher interest payments on loans mean some borrowers may struggle with their repayments, which increases the risks faced by banks. But UK banks are resilient and are strong enough to support their customers.
We have maintained the UK Counter Cyclical Capital Buffer at 2%. This ‘rainy day' buffer can be used to make sure banks can withstand potential losses without restricting lending to the wider economy.
Many UK firms rely on financial markets to raise funding, and disruption to these markets can increase the cost of borrowing for households and businesses more generally. It is therefore important for UK financial stability that these markets function well, even under stress. We are continuing to help develop global standards to limit vulnerabilities in the non-bank participants in these markets.
The global economic outlook is highly uncertain, and the risk environment is challenging
Parts of the global financial system remain vulnerable to potential stresses. The risks include a worsening economic outlook, continued high inflation, and geopolitical tensions.
Earlier this year, we saw the failure of three mid-sized banks (including Silicon Valley Bank) in the US, and the failure of a large bank (Credit Suisse) in Switzerland. There have been no lasting effects from these global banking stresses on UK banks.
However, in recent months, interest rates have continued to increase as central banks around the world act to tackle persistent inflation. The future path of interest rates is also uncertain.
Higher interest rates are making it harder for households and businesses in many countries to service their debt. Certain sectors face particular challenges, including highly indebted businesses and global commercial property markets.
Chart 1: Global interest rates have increased sharply since December 2021
- Source: See Section 1 of the Financial Stability Report – July 2023.
UK household and business finances are under pressure from higher borrowing costs
UK households are facing challenges from increased living costs and higher interest rates. As fixed-rate mortgage deals expire and households renew their mortgages, the average cost of mortgage payments will continue to increase (see Chart 2).
Although the proportion of income that UK households overall spend on mortgage payments is expected to rise, it should remain below the peaks experienced in the Global Financial Crisis and in the early 1990s (see Chart 3).
UK banks are in a strong position to support customers who are facing payment difficulties. This should mean lower defaults than in previous periods in which borrowers have been under pressure.
In 2014, the FPC introduced rules which have also helped to limit the build-up of risk in the mortgage market.
The proportion of businesses spending a high proportion of their income on servicing their debt is also expected to increase this year, but should also remain below previous peaks. Overall, UK businesses are expected to remain broadly resilient as the impact of higher interest rates comes through, but there will be increased pressure on some smaller and highly indebted businesses.
Chart 2: Mortgage payments will continue to increase for many households
Number of owner-occupier mortgages which will experience increases in monthly mortgage costs, by end-2023 and end-2026.
- Source and notes: See Section 2.1 of the Financial Stability Report – July 2023.
Chart 3: Although the proportion of income that all UK households* collectively spend on mortgage payments is expected to rise, it should remain below previous peaks
Aggregate UK household mortgage debt service ratio with illustrative projection to end-2025
- Source and notes: See Section 2.1 of the Financial Stability Report – July 2023.*Including households without mortgages.
UK banks remain strong enough to support households and businesses – even if future economic conditions are worse than we expect
Higher interest payments on loans mean some households and businesses may not be able to make their payments. This increases the risks that banks may face some losses.
However, UK banks are resilient and they are strong enough to continue supporting households and businesses through a period of higher interest rates. In line with our rules, they have large capital buffers to absorb losses.
And, so far, although some households and business have been under increased pressure, banks have not seen a big rise in borrowers being unable to make loan payments. Increases in interest rates feed through to the economy gradually, so the full impact is yet to be felt by households and businesses.
We recently tested the major UK banks using a severe stress scenario that is much worse than the economic outlook we expect. The stress scenario included the unemployment rate increasing to 8.5%, inflation rising to 17%, and house prices falling by 31%.
The results of this stress test showed that the UK banking system would continue to be resilient, and be able to support households and businesses, even if economic conditions turned out to be much worse than we expect (see Chart 4).
As borrowing costs have increased, the demand for loans has reduced. Banks do not appear to be cutting the availability of credit in a way that is out of line with changes in borrower creditworthiness.
We set the The countercyclical capital buffer (CCyB) UK countercyclical capital buffer (CCyB) rate each quarter. This provides banks with an additional ‘rainy day’ buffer making sure they can withstand potential losses without restricting lending to the wider economy. The UK CCyB rate has been maintained at 2%.
Chart 4: Major UK banks are resilient and their capital positions remain above the ‘hurdle rate’ even under a severe stress scenario
- Source and notes: See Section 3.1 of the Financial Stability Report – July 2023.
Non-bank financial institutions continue to need more resilience. We are working internationally to achieve this
Market-based finance is an important source of funding for UK corporates (see Chart 5).
Many UK firms rely on financial markets to raise funding, and disruption to these markets can increase the cost of borrowing for households and businesses more generally. It is therefore important for UK financial stability that these markets function well, even under stress. We are continuing to help develop global standards to limit vulnerabilities in the non-bank participants in these markets.
There remain vulnerabilities in market-based finance which could become more apparent as interest rates continue to increase. For example, rapid changes in interest rates can lead to liquidity challenges for non-banks, as we saw in September 2022, when the impact of a shock in the liability-driven investment (LDI) sector led to further market dysfunction in UK government bonds. Episodes like this can make push up the cost of borrowing.
There continues to be an urgent need to increase resilience. Many firms involved in market-based finance are not regulated by the Bank of England, so we are working with other regulatory authorities to achieve this.
In late 2022, rapid and large moves in the interest rates on UK government debt exposed weaknesses in liability-driven investment (LDI) funds. The Financial Policy Committee made recommendations in March 2023 to increase the resilience of these funds to interest rate shocks. Since then, the authorities responsible for regulating these funds have published new guidance in this area.
We have also launched a stress test designed to consider how banks and non-banks act in stressed financial conditions. This newly launched exploratory scenario will provide useful insights to help us better understand and address vulnerabilities in market-based finance.
Chart 5: Market-based finance is an important source of funding for UK corporates
Composition of the current stock of UK corporate debt
- Source and notes: See Section 5.1 of the Financial Stability Report – July 2023.
The Financial Policy Committee (FPC) seeks to ensure the UK financial system is prepared for, and resilient to, the wide range of risks it could face – so that the system is able to absorb rather than amplify shocks, and serve UK households and businesses.
Key developments since the December 2022 FSR
Since the December 2022 Financial Stability Report, global interest rates have risen further, reflecting actual and expected increases in central bank policy rates in response to continued inflationary pressure. Returning inflation to target sustainably will support the FPC’s objective of protecting and enhancing UK financial stability.
The sharp transition to significantly higher interest rates and greater market volatility over the past 18 months has, however, created stress in the financial system through a number of channels. The failure of three mid-sized US banks – and the failure of a global systemically important bank (G-SIB), Credit Suisse, due to long-running concerns about its risk management and profitability – caused a material rise in financial market risk premia and volatility earlier this year. The impact on the UK banking system through lower bank equity prices and increases in funding costs was limited, and market risk sentiment has stabilised since then. Nonetheless, elements of the global banking system and financial markets remain vulnerable to stress from increased interest rates, and remain subject to significant uncertainty, reflecting risks to the outlook for growth and inflation, and from geopolitical tensions.
In the UK, given the prevalence of variable-rate and short-term fixed-rate mortgages and other loans, the impact of higher interest rates is relatively lower in the financial system than in the real economy, compared to some other jurisdictions.
The UK economy has so far been resilient to interest rate risk, though it will take time for the full impact of higher interest rates to come through. In the financial system, interest rate risks crystallised in Autumn 2022, with stress in liability-driven investment (LDI) funds requiring a temporary and targeted intervention by the Bank. The ability of those funds to absorb shocks has since been reinforced through the setting of new standards, and the rest of the UK financial system has so far been resilient to higher interest rates. This is partly due to the range of regulatory measures introduced after the global financial crisis to manage interest rate risk and to build resilience into the financial system more generally.
The impact of higher interest rates on UK household and corporate debt vulnerabilities
Higher interest rates increase debt-servicing costs facing household and business borrowers. This makes them more likely to cut back on spending, worsening the economic environment, and increases the risk that they will default on loans. Both these factors increase credit risks for lenders.
In the UK, more households are being affected by higher interest rates as fixed-rate mortgage deals expire. The proportion of households with high debt service ratios, after accounting for the higher cost of living, has increased and is expected to continue to do so through 2023. But it is projected to remain some way below the historic peak reached in 2007.
There are several factors that should limit the impact of higher interest rates on mortgage defaults. Given robust capital and profitability, UK banks have options to offer forbearance and limit the increase in repayments faced by borrowers, including by allowing borrowers to vary the terms of their loans. There are now stricter regulatory conduct standards for lenders with respect to supporting households in payment difficulties. And on 23 June, the principal mortgage lenders, the Chancellor and the Financial Conduct Authority (FCA) agreed new support measures for mortgage holders.
The FPC’s mortgage market measures, introduced in 2014 – including its loan to income flow limit on lending to borrowers with high loan to income ratios at or above 4.5 – and the FCA’s responsible lending requirements, have limited the build-up of household indebtedness in the mortgage market. This has increased borrower resilience and played a role in reducing payment difficulties for residential mortgagors.
Buy-to-let mortgagors are also experiencing increases in mortgage interest payments, and other structural factors are also likely to put pressure on their incomes. This could cause landlords to sell, putting downward pressure on house prices. Alternatively, they may seek to continue to pass on higher costs to renters. Similar to other forms of borrowing, buy-to-let mortgages are subject to affordability testing. In 2016, the PRA issued a supervisory statement outlining its expectations for underwriting standards in the buy-to-let market to safeguard against a deterioration in such standards.
The overall number of mortgages in arrears increased slightly over the first quarter of 2023 but remained low by historical standards. It will take time for the full impact of higher interest rates to come through.
The UK corporate sector is expected to remain broadly resilient to higher interest rates and weak growth. Nevertheless, higher financing costs are likely to put pressure on some smaller or highly leveraged firms. The debt-weighted proportion of medium and large corporates with low interest coverage ratios is projected to continue to increase throughout 2023 as debts are refinanced at higher rates, although it is expected to remain some way below previous peak levels.
While corporate insolvency rates have risen above pre-Covid rates, they remain low relative to longer-term average levels. The large majority of the increase in insolvencies has been among very small firms that hold little debt, and a high proportion of the debt they do hold is fixed at low rates and government guaranteed. More broadly, the corporate sector has been repaying debt and its near-term refinancing needs appear limited.
UK banking sector resilience in the context of higher interest rates
The UK banking system is well capitalised and maintains large liquidity buffers. Asset quality overall remains relatively strong, with higher interest rates having had a limited impact on credit risk so far. However, the overall risk environment is challenging. Some forms of lending, such as to finance commercial real estate investments, buy-to-let, and highly leveraged lending to corporates – as well as lenders that are more concentrated in those assets – are more exposed to credit losses as borrowing costs rise.
Major UK banks’ capital and liquidity positions remain robust and profitability has increased, which enables them both to improve their capital positions and to support their customers.
In aggregate, smaller lenders are also well capitalised and maintain strong liquidity positions. These lenders typically hold greater amounts of capital as a share of their risk-weighted assets, relative to regulatory requirements, than larger firms and maintain significant liquidity buffers.
The results of the 2022/23 stress test indicate that the major UK banks are resilient to a severe stress scenario that incorporates persistently higher advanced economy inflation, increasing global interest rates, deep simultaneous recessions in the UK and global economies with materially higher unemployment, and sharp falls in asset prices. The stress test scenario is not a forecast of macroeconomic and financial conditions in the UK or abroad. Rather, it represents a ‘tail risk’ scenario designed to be severe and broad enough to assess the resilience of UK banks to a range of adverse shocks.
The rise in interest rates from a low level has increased bank net interest margins in aggregate. But the fact that higher rates also reduce the market value of banks’ fixed-rate assets can present risks to all banks. UK banks manage these risks through their hedging practices within a regulatory framework that includes rules designed to ensure that UK banks have capital against interest rate risks in their banking book, the maintenance of substantial liquid asset buffers, supervision by the PRA, and regular stress testing.
The FPC continues to judge that the UK banking system is resilient, and has the capacity to support households and businesses through a period of higher interest rates, even if economic and financial conditions were to be substantially worse than expected.
The FPC judges that the tightening of lending standards seen over recent quarters does not reflect banks restricting lending primarily to protect their capital positions. The FPC will continue to monitor UK credit conditions for signs of tightening that are not warranted by changes in the macroeconomic outlook.
The FPC agreed to maintain the UK countercyclical capital buffer (CCyB) rate at 2%. This will help to ensure that banks have sufficient capacity to absorb future shocks without unduly restricting lending. The FPC stands ready to vary the UK CCyB rate, in either direction, in line with the evolution of economic and financial conditions, underlying vulnerabilities, and the overall risk environment.
The impact of higher interest rates on global vulnerabilities
Higher interest rates have affected households and businesses in other advanced economies in similar ways. Jurisdictions where long-term fixed-rate mortgages are more prevalent are likely to have financial sectors that are more naturally exposed to interest rate risk. Riskier corporate borrowing in financial markets – such as private credit and leveraged lending – appears particularly vulnerable, and global commercial real estate markets face a number of short and longer-term headwinds that are pushing down on prices and making refinancing challenging.
Lessons from the recent global banking sector stress
The UK’s regulatory and institutional framework has supported UK financial stability through recent stresses in parts of the global banking system, underlining the importance of maintaining robust macroprudential, regulatory and supervisory standards. Nevertheless, the FPC will draw lessons from the episode.
For example, the impact of the stress underscored how contagion can spread across and within jurisdictions, even where smaller institutions are involved. It also highlighted that while an individual institution may not be considered systemic, if a risk is common – or perceived to be common – among similar institutions, the collective impact can pose a systemic risk.
The stress highlighted the need for all banks to be adequately capitalised against the risks they are exposed to, including interest rate risk. This is consistent with the PRA’s current regulatory frameworks, as well as its initiative to maintain the resilience of the smallest UK banks while considering measures to simplify regulatory requirements for these lenders, known as ‘Strong and Simple’.
Deposit outflows at some regional US banks were large and rapid, with digital banking technology and social media playing a role in increasing the speed at which information was shared and deposits withdrawn. The Bank will contribute to relevant international work to consider whether lessons can be learnt for the liquidity framework for banks, or components of it, in the light of the size and pace of outflows witnessed in recent events.
These events also showed the importance of being able to resolve firms effectively and of maintaining confidence in resolution frameworks. In co-ordination with HM Treasury, the Bank is seeking to ensure that for small banks, which do not need to hold additional resources to meet the minimum requirement for own funds and eligible liabilities (MREL), there are resolution options that improve continuity of access to deposits and so outcomes for depositors. The FPC supports this work. The stress also demonstrated the importance of international authorities’ commitment to ensuring that the resolution framework and plans for G-SIBs, in line with Financial Stability Board (FSB) standards, remain credible.
The resilience of market-based finance
Vulnerabilities in certain parts of market-based finance (MBF) remain. These could crystallise in the context of the current interest rate volatility, amplifying any tightening in financial conditions.
Although the business models of some non-bank financial institutions (NBFIs), such as pension funds and insurance companies, mean that they can benefit from the impact of higher interest rates, the use of derivatives to hedge their interest rate exposures can create material liquidity risk. Liquidity risks also arise when NBFIs use derivatives and repo to create leverage. These liquidity risks must be managed, as evidenced by the LDI stress seen in September 2022.
The risks from higher interest rates can also be amplified by NBFIs deleveraging and rebalancing their portfolios. The FPC will continue to develop its approach to monitoring such risks as the financial system adjusts to higher interest rates.
There continues to be an urgent need to increase resilience in MBF globally. Alongside international policy work led by the FSB, the UK authorities are also working to reduce vulnerabilities domestically where it is effective and practical.
For example, in March 2023, the FPC recommended that The Pensions Regulator (TPR) take action as soon as possible to mitigate financial stability risks by specifying the minimum levels of resilience for the LDI funds and LDI mandates in which pension scheme trustees may invest. Since then, both the FCA and TPR have published detailed guidance on LDI resilience. The FPC welcomes this guidance and the steps taken by TPR and the FCA to ensure the continued resilience of LDI funds. In recent months as interest rates have risen further, funds have in general maintained levels of resilience consistent with the minimum levels recommended by the FPC in March, and have initiated recapitalisation at higher levels of resilience than previously. The Bank will continue working with the FCA, TPR and overseas regulators to monitor the resilience of LDI funds closely.
The Bank has recently launched its system-wide exploratory scenario (SWES) exercise, which will be the first exercise of its kind. It aims to improve understanding of the behaviours of banks and non-bank financial institutions in stressed financial market conditions. It will explore how these behaviours might interact to amplify shocks in financial markets that are core to UK financial stability. In bringing together information from various parts of the financial system to develop system-wide (and sector-specific) insights, it will be able to account for interactions and amplification effects within and across the financial system that individual financial institutions working alone cannot assess. The FPC supports the SWES and considers it an important contribution to understanding and addressing vulnerabilities in market-based finance.
1: Developments in financial markets
Since the December 2022 Financial Stability Report, global interest rates have risen further. This reflects actual and expected increases in central bank policy rates in response to continued inflationary pressure. The outlook for global growth has improved slightly, despite stress in the global banking system and continued heightened geopolitical uncertainty. Although UK growth prospects remain subdued, they have also improved somewhat since December, supported by lower energy prices.
UK government bond yields have risen sharply in recent months, mainly reflecting increases in the expected path of Bank Rate given recent inflation outturns. US and European government bond yields have also increased, but by less than UK gilt yields.
The failure of three mid-sized US banks – and the failure of a globally systemically important bank, Credit Suisse, due to long-running concerns about its risk management and profitability – caused a material rise in financial market risk premia and volatility earlier this year. US bank equity prices fell significantly as a result, and have not recovered. UK and European bank equity prices fell by a smaller amount, and have since partially recovered.
Market risk sentiment has since stabilised. But global financial markets remain subject to significant uncertainty, reflecting underlying uncertainties about the outlook for growth, inflation and interest rates. Volatility in some interest rate markets – such as gilts and short-dated US Treasuries – has been particularly elevated.
Global risky asset valuations look broadly in line with their recent historical distributions, with the possible exception of US equities, where certain technology stocks in particular are highly valued relative to historical distributions. However, given the current level of macroeconomic uncertainty, there is a risk that further unanticipated increases in market interest rates and interest rate volatility, or a deterioration in the economic outlook, could lead to sharp reductions in risky asset prices, further tightening financial conditions for UK households and businesses.
Global interest rates have risen further as inflationary pressure has continued, but the outlook for global growth has improved slightly.
Since the December 2022 FSR, the global outlook for growth has improved slightly, despite stress in the global banking system and continued heightened geopolitical uncertainty. But global growth is still expected to remain subdued, and risks to the outlook remain. UK growth prospects also remain subdued.
UK and European wholesale gas spot prices are around a quarter of the level seen at the time of the December 2022 FSR. This is below the level seen before Russia’s invasion of Ukraine in February 2022 but still well above their pre-Covid average.
However, despite lower energy prices in the UK and Europe, global inflationary pressures have continued. Central bank policy rates in advanced economies have increased in response. The market-implied near-term path for UK Bank Rate has increased further since the December FSR, and is now expected to peak at around 6.2% in early 2024.
Yields on 10-year UK government bonds have risen sharply since the December FSR, particularly in May. This mainly reflects increases in market expectations for the path of Bank Rate given recent inflation data. Yields on US and European government bonds are also higher than at the time of the December FSR, but have increased by less than UK gilt yields (Chart 1.1).
Chart 1.1: Since the December FSR, yields on 10-year government bonds have increased by more in the UK than in the US and euro area
Changes in 10-year government bond yields since the beginning of 2022
- Sources: Bloomberg Finance L.P. and Bank calculations.
At the beginning of 2023, stronger risk appetite was evident in credit markets, but volatility in rates markets had remained elevated.
Stronger risk appetite had been evident in movements in global corporate bond and leveraged-loan spreads at the start of 2023. Liquidity in UK gilt markets had largely recovered from the disruption in Autumn 2022 (Chart 1.2). But volatility in interest rates markets remained elevated globally (Chart 1.3). In part, this reflected the fact that uncertainty over the path of policy rates remained high.
Chart 1.2: Liquidity conditions became more challenging in March reflecting heightened market volatility
10-year cash gilt bid-ask spread and price impact for gilt futures (a)
- Sources: Bloomberg Finance L.P., BMLL Technologies and Bank calculations.
- (a) Price impact measures how gilt futures prices change in response to changes in the orderbook, eg when futures contracts are bought or sold. The measure is calculated using BMLL data in line with methodology set out in Cont, Kukanov and Stoikov (2014).
Chart 1.3: Volatility in US Treasury markets has been highly elevated
Five day average of Merrill Lynch Option Volatility Estimate for interest rates (MOVE index) (a)
US bank equity prices fell following the failure of three US banks, impacting wider financial markets.
In the first half of this year, three US banks – Silicon Valley Bank (SVB), Signature Bank, and First Republic Bank – failed, following substantial deposit outflows prompted by concerns over poor management of interest rate risk and liquidity risk. Credit Suisse, which had previously experienced a series of risk-management, business model and profitability concerns, came under renewed pressure, and was ultimately taken over by UBS, following an intervention by the Swiss authorities (see Section 4).
Aggregate US bank equity prices fell sharply following these events. There were particularly large falls among smaller regional banks where investor concerns were concentrated, with equity prices falling by around 30% in March (Chart 1.4). UK and European bank equities fell by 17% and 18% respectively.
Following this stress – and against a backdrop of broader market uncertainty – there was a material increase in spreads on high-yield and investment-grade corporate bonds and leveraged loans (Chart 1.5). Credit default swap index spreads also widened. Volatility in equities, and credit markets increased sharply, and remained somewhat elevated due the uncertainty around the raising of the US government debt ceiling, which has since been resolved. Gilt market liquidity conditions became more challenging during this period given broader volatility in financial markets.
Chart 1.4: US regional bank equity prices fell sharply in March and have failed to recover, while UK and European bank equities have partially recovered
Global bank equity price indices (a)
Chart 1.5: Credit spreads increased after the market disruption in March; most remain slightly above their historical average
- Sources: Datastream from LSEG, ICE data indices, LCD, a part of PitchBook, and Bank calculations.
- (a) Data points for high-yield and investment-grade spreads are five-day rolling averages as at 30 June 2023, 21 March 2023 (when the impact of the global banking stress on spreads peaked) and 8 March 2023 (prior to the stress). For leveraged-loan spreads, the averages are taken to the previous Friday in each case (3 March, 17 March and 30 June 2023).
- (b) Data series go back to 1998 (investment-grade and high-yield spreads), 2000 (US leveraged-loan spreads), and 2002 (UK and European leveraged-loan spreads).
- (c) For high-yield and investment-grade spreads, UK, US and EU represent spreads on debt issued in sterling, US dollars and euros, respectively.
Market conditions have partly recovered from the disruption in March, but global financial markets remain subject to significant uncertainty around interest rates, related to the outlook for growth and inflation.
US bank equity prices have failed to recover from the March stress (Chart 1.4). Meanwhile, European and UK bank equity prices have partly recovered.
Spreads on corporate bonds have also partly retraced to lower levels. That said, spreads are still slightly elevated and risky debt issuance is subdued, especially in the leveraged-loan market, which may reflect a lasting increase in risk aversion among investors. If the economic outlook were to deteriorate, then spreads could widen sharply again.
Volatility in equity and credit markets has fallen back, but remains high in some rates markets – particularly for gilts and shorter-dated US treasuries – reflecting uncertainty in the expected path of global growth and inflation (Chart 1.3). Since March, gilt market liquidity conditions have improved overall, but bid-ask spreads for 10-year UK gilts have remained somewhat elevated (Chart 1.2).
Global equity market valuations look broadly in line with their recent historical distributions.
So far, equity prices have been largely resilient to the recent increases in global interest rates. The market capitalisation of the S&P 500 has increased by around 11% since the December FSR, while the EuroStoxx 600 has increased by around 5%. The UK stock market has been broadly flat. In the US, recent gains have been concentrated in large technology companies, which have been trading at over 26 times forward earnings, 44% above the four-year average for that metric. In Europe, the equity market gains have been more broad-based, supported by recent falls in energy prices.
Excess cyclically adjusted price-to-earnings (CAPE) yield – a measure of the excess return that investors expect from equities relative to risk-free investments – on US equities is now around the lowest it has been since before the global financial crisis, driven in large part by the recent gains among large technology companies. However, valuations appear less stretched relative to a longer time series (Chart 1.6).
Chart 1.6: US equity valuations are high relative to recent history, but appear less stretched relative to a longer time series
Excess cyclically adjusted price-to-earnings yield
- Sources: Bloomberg Finance L.P., Federal Reserve Bank of St Louis and Bank calculations.
Nonetheless, if market participants were to re-evaluate materially the prospects for growth, inflation or interest rates, this could lead to sharp reductions in asset prices, further tightening financial conditions for households and businesses.
Higher interest rates combined with an uncertain outlook for growth can trigger a revaluation of asset prices. Sharp decreases in asset prices could amplify financial stability risks to the UK by tightening financial conditions further, impairing businesses’ ability to raise finance, and increasing the cost of bond and equity issuance.
A sharp reduction in asset values could also directly affect the financial system; for example through direct losses on asset holdings; by reducing the value of collateral securing existing loans; or by creating sharp increases in the demand for liquidity. Any such moves could be amplified by vulnerabilities in market-based finance, and would tighten financial conditions for UK households and businesses. The Financial Policy Committee continues to work with the international policy community to improve the resilience of market-based finance (see Section 5).
Higher interest rates increase debt-servicing costs for household and business borrowers. This increases the likelihood that they will default on loans, which in turn increases credit risks for lenders. This is the main channel through which households and businesses can affect financial stability.
Higher interest rates are affecting more households as fixed-rate mortgage deals expire, pushing up the aggregate mortgage debt-servicing burden. In the private rented sector, buy-to-let landlords are also being affected by higher rates, which, along with other pressures, has caused some to sell up or pass on higher costs to renters. Households’ use of consumer credit has increased, which could in part reflect these trends. Mortgage and consumer credit arrears rates have, however, remained low so far.
There are several factors that should limit the impact of higher interest rates on mortgage defaults. Given robust capital and profitability, UK banks have options to offer forbearance and limit the increase in repayments faced by borrowers, including by allowing borrowers to vary the terms of their loans. There are now stricter regulatory conduct standards for lenders with respect to supporting households in payment difficulties. And on 23 June, the principal mortgage lenders, the Chancellor and the Financial Conduct Authority (FCA) agreed new support measures for residential mortgage holders.
The FPC’s mortgage market measures, introduced in 2014, including its loan to income (LTI) flow limit on lending to borrowers with LTIs at or above 4.5, have limited the build-up of household indebtedness in the mortgage market. This has increased borrower resilience and played a role in reducing payment difficulties for mortgagors.
Higher interest rates are also putting some firms under pressure, but the UK corporate sector is expected to remain broadly resilient to higher interest rates and weak growth. Nevertheless, higher financing costs are likely to put pressure on some smaller or highly leveraged firms. The debt-weighted proportion of medium and large corporates with high interest payments relative to earnings is projected to continue to increase throughout 2023 as debts are refinanced at higher rates, although that proportion is expected to remain some way below previous peak levels. In aggregate, corporates’ near-term market-based debt refinancing needs are relatively limited.
Corporate insolvencies have increased, although the rate remains low compared to historical levels. The large majority of this recent increase in total insolvencies has been among smaller companies, and much of these firms’ debt is government-guaranteed, acquired during the pandemic at low, fixed rates of interest.
The 2022/23 annual cyclical scenario (ACS) results indicate that the UK banking system would be resilient to its exposures to UK households and corporates in the event of a severe macroeconomic scenario involving large falls in GDP and asset prices, high interest rates globally and large increases in unemployment.
The Monetary Policy Committee (MPC) has increased Bank Rate by two percentage points to 5% since the December 2022 FSR, and market expectations are for Bank Rate to average around 5.5% over the next three years. Headline CPI inflation has recently begun to fall from recent peaks, but core inflation has been persistent, and the MPC judges that the risks to its May inflation projection are skewed significantly to the upside.
The outlook for UK economic growth remains subdued but has improved since the December 2022 FSR, consistent with stronger global growth and lower energy prices. The MPC now expects UK GDP growth to be slightly positive across its three-year forecast period and it expects unemployment to be lower than previously forecast, remaining below 4% until the end of 2024.
These macroeconomic variables inform the FPC’s assessment of the outlook for household and corporate debt vulnerabilities. For example, higher interest rates make debt-servicing more expensive, while lower expected unemployment reduces the number of households likely to experience sharply reduced incomes – unemployment has historically been a key driver of defaults.
The FPC has previously identified two main channels through which high levels of household or corporate debt can pose risks to the UK financial system or wider economy:
- Lender resilience. If highly indebted households and businesses get into difficulties making debt repayments and default, this can lead to losses for lenders and test their resilience.
- Borrower resilience. Highly indebted households and businesses may cut back sharply on consumption, investment, or employment to make debt repayments, and hence amplify macroeconomic downturns.
Both borrower and lender resilience can be adversely affected by a number of factors, including higher debt-servicing costs, lower business and household incomes, and higher unemployment.
2.1: UK household debt vulnerabilities
There was a fall in the volume of mortgage approvals around the turn of the year, following significant increases in mortgage rates in late 2022. Mortgage approvals have since somewhat recovered but remain below their historical average. Against this backdrop, house prices have seen a decline, but they are still substantially above pre-Covid levels given the significant price growth since 2020 (Chart 2.1).
Chart 2.1: Indicators of UK house prices have declined from 2022 peaks
House price indices (a)
- Sources: UK House Price Index from the HM Land Registry, Registers of Scotland, Land and Property Services Northern Ireland and Office for National Statistics, Halifax, Nationwide, Rightmove.co.uk and Bank calculations.
- (a) The latest data point for the UK House Price Index is April 2023. Halifax, Nationwide and Rightmove data are advanced to reflect the respective timing of each data source in the house-buying process.
Changes in market expectations around the path of Bank Rate are reflected in the overnight index swap rate (OIS). The OIS is used by lenders to price their mortgage products. Rates on a 75% loan to value (LTV) mortgage fixed for five years stood at around 5% in June, and for an equivalent two-year fixed-rate mortgage rates were around 5.5% (Chart 2.2).
Mortgage lenders take time to adjust their pricing as market interest rates change. Spreads widened appreciably in 2022 Q4, as lenders responded to heightened volatility and rapid increases in market rates. Spreads have subsequently fallen back.
Chart 2.2: Mortgage rates have recently increased
Average quoted rates on two-year and five-year fixed-rate mortgages with 75% LTV, and the two-year and five-year OIS rates (a)
Higher interest rates are impacting more households as fixed-rate mortgage deals expire.
The majority of mortgages taken out over recent years have been at a fixed interest rate for a period of time (most commonly two or five years), so higher interest rates affect mortgagor households in aggregate with a lag. Around half of mortgage accounts (around 4.5 million) are estimated to have seen increases in repayments since mortgage rates started to rise in late 2021. And higher rates are expected to affect the vast majority of the remainder by the end of 2026 (around 4 million accounts). For the typical mortgagor rolling off a fixed-rate deal over the second half of 2023, monthly interest payments would increase by around £220 if their mortgage rate rises by the 325 basis points implied by current quoted mortgage rates. Chart 2.3 shows a projection of the distribution of payment increases across all mortgages (including variable rate) to the end of 2026.
Chart 2.3: Mortgage payments will increase for many households
- Sources: Bloomberg Finance L.P., FCA Product Sales Data and Bank calculations.
- (a) The projection uses the OIS curve as at 30 June 2023 and the latest available data (end-2022) on the stock of outstanding mortgages.
- (b) Increases in payments on variable-rate mortgages are calculated using the implied uplift in the OIS curve and payments increase for fixed-rate mortgages are calculated by assuming that mortgagors refinance onto a typical fixed rate at the point that their fixed-rate contract ends.
- (c) Mortgages with less than £1,000 outstanding are excluded. These data do not include buy-to-let mortgages or mortgages that are off balance sheet of authorised lenders, such as securitised loans or loan books sold to third parties.
Households’ aggregate mortgage debt-servicing burden is expected to increase but remain below historical peaks…
Higher mortgage rates increase the mortgage servicing burden on UK households. The aggregate mortgage debt-servicing ratio (DSR), which measures the proportion of post-tax income spent on mortgage payments across all households (both mortgagor and non-mortgagor), is projected to increase from 6.2% to around 8% by mid-2026. If that were the case, this share would remain below the peaks seen in both the 2007–08 global financial crisis (GFC) and the early 1990s recession (Chart 2.4), despite interest rates now being at a similar level to those prior to the GFC.footnote 
Chart 2.4: Aggregate mortgage debt-servicing burdens are expected to increase but to remain below previous peaks
- Sources: Bank of England, Bloomberg Finance L.P., FCA Product Sales Data, ONS and Bank calculations.
- (a) Calculated as interest payments plus mortgage principal repayments as a proportion of nominal household post-tax income. Household income has been adjusted to take into account the effects of Financial Intermediation Services Indirectly Measured. Mortgage interest payments before 2000 are adjusted to remove the effect of mortgage interest relief at source.
- (b) For the illustrative projections to mid-2026, projections for household post‑tax income consistent with the May 2023 MPR. Payment increases are projected using market expectations for Bank Rate based on the OIS curve as at 30 June, taking into account the distribution of fixed-deal terms from the FCA Product Sales Data and assuming the aggregate mortgage debt to income ratio remains constant.
Relatedly, the aggregate UK household debt to income ratio, which measures total indebtedness, is now materially lower, at 118% in 2023 Q1, than the GFC peak, where it reached around 150% (Chart 2.5).
Household debt as a share of income, excluding student debt
- Sources: Bank of England, ONS, and Bank Staff Calculations.
…and the proportion of individual households facing the highest mortgage repayments is also expected to increase, but to stay below previous highs.
Another way of tracking household debt vulnerabilities is by measuring how much of their income, after tax and essential spending, individual households need to spend on mortgage or consumer credit debt repayments. Households with higher mortgage cost-of-living-adjusted debt-servicing ratios (COLA-DSRs), and in particular those with mortgage COLA-DSRs over 70%, are more likely to face difficulties in meeting their debt repayments. A significant increase in borrower defaults could have implications for lender resilience.
Rising mortgage costs have led to an increase in the proportion of ‘high’ mortgage COLA-DSRs as a percentage of total households, from 1.6% in 2022 Q3 to 2.0% in 2023 Q1 (Chart 2.6).footnote  Consistent with this, the number of owner-occupier mortgages in arrears (of 2.5% or more of the outstanding balance) increased slightly over the first quarter of 2023, but, at 0.9% of outstanding mortgages, it remained low by historical standards. However, it will take time for the full impact of higher interest rates to come through.
The proportion of households with high mortgage COLA-DSRs is expected to continue to increase throughout 2023 to around 2.3%, or around 650,000 households, by the end of the year (Chart 2.6). But it should stay below the recent peak reached in 2007 of 3.4%, or around 870,000 households.footnote  To reach that peak level by the end of 2024, it would require mortgage rates to be around three percentage points higher relative to current expectations, other things equal.
Chart 2.6: The share of total households with high mortgage debt-servicing burdens is projected to increase this year
- Sources: Bank of England, Bloomberg Finance L.P., British Household Panel Survey/Understanding Society (BHPS/US), NMG Consulting survey, ONS and Bank calculations.
- (a) The threshold of 70% is estimated by taking the threshold at which households become much more likely to experience repayment difficulties for gross DSRs (40%) and adjusting it to reflect the share of income spent on taxes and essentials (excluding housing costs) by households with mortgages. For more information on the gross threshold, see the August 2020 FSR.
- (b) The impact of inflation is estimated by assuming the prices of essential goods rise in line with the May 2023 MPR inflation projection, and that households do not substitute away from this consumption. Interest rate projections are applied based on OIS rates as at 30 June 2023.
Given robust capital and profitability, UK banks have options to offer forbearance and limit the increase in repayments faced by borrowers, including by allowing borrowers to vary the terms of their loans. There are now stricter regulatory conduct standards for lenders with respect to supporting households in payment difficulties. And on 23 June, the principal mortgage lenders, the Chancellor and the Financial Conduct Authority (FCA) agreed new support measures for residential mortgage holders.footnote 
The FPC’s mortgage market measures, introduced in 2014, including its flow limit on lending to borrowers with LTIs at or above 4.5, have limited the build-up of household indebtedness in the mortgage market. This has increased borrower resilience and played a role in reducing payment difficulties for mortgagors.footnote 
The FCA’s Mortgage Conduct of Business (MCOB) rules continue to guard against the risk that mortgage repayments become unaffordable. Lenders have recently been stressing borrowers at higher interest rates of around 8.5% compared to 7% in 2022 Q1. This has led to a reduction in aggregate mortgage lending, and lending at high LTIs has fallen.
There is evidence that some households are taking up the option to borrow over longer terms, as they attempt to offset the impact of higher mortgage rates by reducing monthly capital repayments. New lending at terms longer than 35 years has increased from around 5% in 2022 Q1 to 11% in 2023 Q1. And of those borrowers who remortgaged in 2023 Q1, around 15% extended their existing term.
Higher interest rates, together with other factors, are also putting pressure on buy-to-let landlords’ profitability, which has caused some to sell up or pass on higher costs to renters.
The private rented sector is an important part of the UK housing market, covering around 19% of households. Many private landlords finance their investment through mortgage borrowing: around 7% of the total UK housing stock has a buy-to-let (BtL) mortgage on it and this type of lending comprises around 18% of the overall mortgage market by value.
Landlords are currently subject to a combination of factors that are putting pressure on their profitability: higher interest rates and structural changes – including adjustments to income and capital gains tax rules and proposed changes to building energy efficiency regulations and tenancy protection. The interest coverage ratio (ICR), which is a measure of rental income relative to interest payments, shows the extent to which a landlord’s rental income covers their cost of borrowing. A landlord with high debt-servicing costs relative to their rental income (ie a low ICR) is more likely to experience repayment difficulties. As with owner-occupier mortgages, higher interest rates mean an increase in mortgage servicing costs when fixed rate deals need to be refinanced, and most BtL mortgages are interest only, which increases the relative impact of higher rates. The average increase in monthly repayments on BtL mortgages by the end of 2025 is projected to be around £275. If landlords were to entirely absorb higher mortgage costs (ie without passing any of them on to renters), the share of BtL mortgages with ICRs below 125% would increase significantly from around 3% at the end of 2022 to just over 40% by the end of 2025.
Falling profitability could, in principle, cause landlords to sell their property investments and exit the BtL market. If this were to happen in large enough volumes, it could put downward pressure on house prices. Sales by some landlords might be offset by purchases by other landlords, and market intelligence suggests that larger-scale, professional landlords are taking up an increasing share of the market as smaller landlords exit. It is difficult to establish a comprehensive view of the net balance, as inflows are harder to measure than outflows and can be lagged. However, available evidence suggests that recent market exit by some landlords has caused a certain degree of shrinkage of the private rented sector as a whole, but not on a scale likely to have a material impact on house prices overall. A range of external estimates suggests that net sales of BtL properties in 2022 are unlikely to have exceeded around 100,000, representing up to around 8% of total house sales that year (and less than 0.4% of the total UK housing stock).
Many landlords are likely to seek to raise rents to offset their higher costs. National rent inflation in the private rental market was 5% year-on-year to May, with one industry estimate indicating a 10% price increase in new lets in the year to June. Renter households tend to have lower incomes than homeowners (including relative to housing costs) and they are likely to have low savings. Higher costs relative to incomes may lead to an increased reliance on consumer credit, or difficulties paying off existing consumer credit or other types of debt. It may also increase their vulnerability to future adverse shocks.
Usage of consumer credit has recently increased, following a contraction during the pandemic.
Consumer credit accounts for around one eighth of total lending to households, with mortgage lending comprising the other seven eighths. Credit card debt makes up a large share of the consumer credit total.
Consumer credit growth has increased after its pandemic-era contraction, with 12% annual growth in credit card lending in the most recent data and total consumer credit lending rising broadly in line with nominal incomes over the past year. Consumer credit is used across the income spectrum. Recent survey data indicates that 15% of adults reported increasing their borrowing in response to cost-of-living pressures at the end of 2022. However, the stock of outstanding debt as a share of incomes remains a little below pre-pandemic levels at around 12% in 2023 Q1.
For households with outstanding consumer credit debts, a consumer credit debt-servicing ratio, adjusted for cost-of-living (COLA-DSR), can be calculated. It measures how much income after taxes, essentials and housing costs is spent on servicing consumer credit debts.footnote  The threshold beyond which households are understood to be more likely to get into financial difficulties (‘high’ consumer credit COLA-DSR), is estimated to be 80%. The proportion of total households with high consumer credit COLA-DSRs has slightly increased over the past year, from around 9% to around 10%, and, assuming constant levels of debt, it is expected to remain broadly flat for the remainder of 2023.footnote 
Aggregate arrears figures for consumer credit have been largely low and stable since 2022, with around 1% of UK banks’ lending in arrears of more than three months. However, within the aggregate, distress among the most indebted may have increased. Contacts in the debt advice charity sector indicate that the scale of difficulties faced by those seeking debt advice has increased, and among households in difficulty recent survey data shows ‘increased balance on credit card’ and ‘increased overdraft’ to be the second and third most cited issues (after ‘behind on bills/utility payments’).
Further deterioration of households’ finances, including higher mortgage or rental payments, could increase pressures on households, potentially leading to higher consumer credit arrears or default rates.
The UK banking system is resilient to its household debt exposures.
As part of the 2022/23 ACS, major UK banks were stress tested against a severe macroeconomic scenario that would put pressure on the ability of households to service their debts, including unemployment rising to 8.5%. Banks have been found to be resilient to expected losses, including a five-year consumer credit impairment rate of 27%.
Banks’ losses (or expected losses) on mortgage lending can depend not only on borrowers’ ability to repay but also on house prices, given mortgage lending is collateralised against the value of the property. A material fall in house prices could increase the LTV ratio on banks’ lending books, reducing their resilience to further declines.
The FPC judges that the UK banking sector is resilient to its mortgage exposures, including in the event of house price falls significantly in excess of external central case projections. The ACS scenario includes a house price fall of more than 30%. Mortgage lenders’ aggregate LTVs are robust, with 87% of their stock of owner occupier mortgages below 75% LTV, helping to provide a sizable buffer against significant house price falls.
For BtL mortgages, 94% of lenders’ stock is below 75% LTV. Similar to other forms of borrowing, BtL mortgages are subject to affordability testing. In 2016, the PRA issued a Supervisory Statement outlining its expectations for underwriting standards in the BtL market to safeguard against a deterioration in such standards.
2.2: UK corporate debt vulnerabilities
Bond finance makes up a significant proportion of large corporates’ total debt. Bonds generally have a fixed interest rate, and corporate issuers will face higher costs when they need to refinance.
For many corporate borrowers, however, and especially small to medium sized enterprises (SMEs), bank credit is their main, or even only, source of finance. Bank loans to corporates are generally floating rate. This means that increases in Bank Rate are likely, on average, to flow through into corporate debt-servicing costs more quickly than for household debt, which over recent years has tended to be fixed rate. Between January 2022 and May 2023 the average interest rate on the stock of floating rate bank loans to corporates rose by over 400 basis points to around 6.5%.
The overall level of corporate indebtedness is relatively low…
In aggregate, the amount of outstanding UK corporate debt relative to corporate earnings, has continued to fall since its recent Covid-era peak. This picture is reinforced if corporates’ holdings of cash are subtracted from their stock of debt. At the end of 2023 Q1, the net debt to earnings ratio stood at around 120%, its lowest point in the past 20 years. This has been driven by both strong growth in nominal earnings and a fall in aggregate leverage. However, debt and cash holdings are not spread evenly and for those companies more reliant on debt, the rise in interest rates has made it more expensive for them to service existing debt and obtain new finance.
…and near-term refinancing needs from financial markets are limited.
The structure of corporate funding in the UK has changed materially over time. Market-based finance now makes up over 50% of the total stock of debt, up from around 40% in 2009. And it accounts for nearly all of the £425 billion net increase in lending to UK corporates since the end of 2007. Market-based finance can, in theory, help provide diversification of funding sources, and hence increase the resilience of the supply of finance to corporates. But it can also introduce additional vulnerabilities: investor sentiment can change rapidly in response to adverse shocks, triggering widening credit spreads and making it harder or more expensive for borrowers to roll-over their debts, even if risk free rates are unchanged. These risks are heightened in riskier credit markets such as leveraged loans, private credit and high-yield bonds. Available deal-level data indicate that these markets account for around 40% of all market-based debt.
The maturity profile of their debt affects the speed with which corporates are exposed to higher interest rates, and the extent to which refinancing pressures could pose risks to financial stability. In aggregate, refinancing needs for market-based term debt in 2023 are relatively limited (Chart 2.7). Even by the end of 2025, refinancing needs appear to be limited in aggregate, with 22% of debt falling due. A slightly higher 30% of leveraged loans are due for refinancing by the end of 2025. And although leveraged lending represents a much smaller proportion of total debt than bonds, the riskier borrowers that rely on it are more likely to find it harder to access credit in the event of unexpected shocks and could be unable easily to access alternative markets. Firms that do not need to refinance in the near-term have time to adjust their balance sheets to the higher interest rate environment.
Chart 2.7: Market-based refinancing needs of UK corporates are relatively limited in the near-term
- Sources: Refinitiv Eikon for bonds, Bloomberg for leveraged loans and Bank staff calculations.
- (a) Investment-grade bonds have a rating of BB+ and above.
- (b) High-yield bonds are BBB and below.
- (c) Leveraged loans are defined as the borrower having a debt to EBIT ratio of 4.5 or above and/or a private equity sponsor.
- (d) Other types of market-based debt, not shown in the chart, are private credit, direct lending funds, loans from insurers and security dealers and finance leasing.
But higher interest rates are putting some firms under pressure.
A company’s ICR is calculated by dividing its earnings before interest and tax (EBIT) by its interest expense. A company with high debt-servicing costs relative to its earnings (ie a low ICR) is materially more likely to experience repayment difficulties. As would be expected against a backdrop of rising borrowing costs, the debt-weighted proportion of medium and large corporates with low ICRs increased in 2022 (Chart 2.8). Assuming that corporates do not deleverage any further, this share is expected to continue to increase during 2023, although it is still expected to remain below previous peak levels.
Unexpected further rate rises would increase the percentage of vulnerable corporates further. An upward shock to funding costs of around 200 basis points above market expectations for Bank Rate would be required for the share of low ICRs to reach the pre-GFC peak (again assuming that corporates take no mitigating actions, such as deleveraging). And the required increase in rates would need to be greater still (around 800 basis points) for the share to match the estimated historical peak in 2000.
Within the aggregate, medium-sized corporates are more likely to have low ICRs than large corporates, although the share of low ICRs for large corporates is projected to increase during 2023, as fixed-rate bonds are refinanced. In practice, however, some companies may choose to repay rather than refinance their debt.
Chart 2.8: Debt-servicing burdens are increasing
- Sources: Moody’s BvD, S&P Global Market Intelligence and Bank calculations.
- (a) These data refer to UK private non-financial corporations (PNFCs) only.
- (b) The projection uses the May 2023 MPR projections for earnings and credit spreads, and OIS rates as at 30 June 2023; these are applied to latest published balance sheet data.
- (c) Firms with turnover less than £10 million are excluded. ‘Medium’ is defined as firms with turnover between £10 million and £500 million, and ‘large’ as greater than £500 million.
- (d) Bank staff have updated the data used to calculate the low ICR share. Consequently, the figures presented here are not directly comparable to those previously published.
Historically, higher interest rates have tended to be associated with a lagged increase in the rate of insolvencies (see Financial Stability in Focus: Interest rate risk in the economy and financial system). Since the December FSR, monthly corporate insolvencies have continued to increase (to around 2,500 in May, up from a Covid-era low of below 700 in early 2021) and have exceeded their pre-Covid level (of around 1,500). Nevertheless, the insolvency rate, as a share of companies, remains low compared to historical levels.
The large majority of this recent increase in total insolvencies has been among smaller ‘micro’ companies.footnote  Many of these firms hold little debt and available evidence indicates that a high proportion of the debt they do hold is government-guaranteed loans from the Covid period, which had low interest rates fixed for six years. This suggests that the subdued macroeconomic environment is leading to the crystallisation of vulnerabilities at some of these firms, as opposed to the direct impact of higher interest rates. And part of the increase is likely to be due to numbers catching up with the historical trend following the end of the covid-era temporary insolvency protections. The insolvency rate for medium and large firms, which account for the vast majority of corporate debt, was largely muted over 2022 but more recently has begun to increase slightly.
Insolvencies are likely to rise further, as pressures caused by higher interest rates and the relatively subdued economic outlook continue to feed through. The UK banking system is well capitalised to withstand increases in corporate distress. As part of the 2022/23 ACS, major UK banks have been stress tested against a broad and severe macroeconomic scenario. The results indicate that they would be resilient to significant credit losses across their portfolios, including on their UK corporate lending (including commercial real estate lending), which had an aggregate projected five-year impairment rate of 8.3%. For context, the current annual corporate loan write-off rate is very low by historical standards at around 0.2%.
Box A: Vulnerabilities in UK and global commercial real estate markets
The commercial real estate market faces a number of short- and longer-term headwinds.
CRE in the UK is a major investment class: the total stock is estimated to be worth over £1 trillion. Around two thirds of this is held by investors, with the remainder being owner-occupied. Relative to the size of the UK economy, however, the market has shrunk from an estimated 65% of GDP in 2007 to 45% in 2022. Although the leverage of investors has also declined (with their debt relative to assets falling from around 60% in 2008 to 40% now), debt remains an important source of funding for investors, and CRE-related debt stands at around 12% of UK GDP. CRE is also an important asset class globally. In the United States, CRE debt as a proportion of GDP is around 17%.
UK CRE prices have fallen by nearly 20% since their mid-2022 peak (Chart A). Higher interest rates are a key factor weighing on prices: absent rent increases, they reduce the profitability of CRE investments relative to other assets such as bonds and increase the servicing costs on any debt. In addition, office and retail investments face specific structural challenges, and these make up around 60% of the total UK CRE stock. The post-pandemic shift to more remote working has contributed to a rise in office vacancy rates, from around 10% in 2018 to over 15% now, and retail has seen a longer-term price decline, partly as a result of more online shopping. The costs of upgrading buildings to meet stricter minimum energy efficiency standards by 2030 is also pushing down on prices.
These challenges for CRE are shared across some advanced economies. CRE prices in the United States and the euro area have so far fallen by less than in the UK, relative to their recent peaks (Chart A). Historically, the UK market has tended to react more quickly than elsewhere. Although real estate investment trusts (REITs) indices suggest that further price falls are likely to come in the UK, they also indicate that further declines in the United States and the euro area are likely to be bigger.
Chart A: Commercial real estate values have declined recently in the UK and elsewhere
CRE price indices for the UK, United States and euro area (a)
Price falls can present a risk to lenders if they materially reduce the value of the collateral held against their loans. Investors are impacted by a decline in the value of their assets, and especially when investors who use leverage need to refinance. Fire-selling by investors would exacerbate any existing market downturn, which would heighten risks to the core financial system.
UK banks are resilient to their exposures to UK CRE.
There has been a structural shift in CRE investors’ funding sources, with UK banks’ share of outstanding debt declining from over 60% in 2008 to just over 30% now. This was partly driven by stricter capital requirements in relation to such loans.
Over the same period, the aggregate loan to value (LTV) ratio of major UK banks’ CRE lending has improved and almost all of it is currently below 75% LTV (as of mid-2022). The results of the 2022/23 ACS, which included a 45% decline in UK CRE prices (as of end of 2022 Q2), suggest that major UK banks would be resilient to significant further falls in CRE prices. In aggregate, their losses on UK and non-UK CRE exposures were less than 7% of their total impairments in the 2022/23 ACS.
As a proportion of their total assets, some smaller UK lenders are more exposed to CRE than larger banks. However, the majority of this exposure is to residential CRE – this sub-sector is less volatile and not facing the same structural challenges as the wider CRE sector, such as offices and retail.
The profile of lenders and investors in UK CRE has changed over time, with more foreign investment than before the global financial crisis.
The trend away from UK bank lending to CRE investors has been associated with a broadening of funding sources. Investors are now more reliant on market-based finance and international banks (Chart B). The resilience of this new funding mix has, however, yet to be tested in a severe CRE market stress event.
Chart B: UK banks are still important for CRE investor funding, but bonds now account for a similar share
Share of CRE investor debt by source, 2022
- Sources: Bayes survey, PRA, Stress Test Data Framework and Bank calculations.
The likelihood of price falls triggering rapid market exit by investors depends to a large extent on the nature of the investor. The majority of UK CRE investors, including institutional investors, have long-term investment horizons and are generally diversified, with UK CRE only comprising a small proportion of their total exposures.
Close-ended REITs (or similar foreign-listed funds) are estimated to hold around 20% of UK CRE investments (around 13% of the total UK CRE market, including owner-occupied). They use debt to boost returns, and if worsening LTVs and profitability make it harder for them to refinance when existing loans fall due in the coming years, they could be forced to take out costlier debt, deleverage or default.footnote  Open-ended funds are more vulnerable to rapid redemptions in the event of market stress (although they can suspend or defer redemptions to avoid fire sales). However, the market share of these funds has declined since 2016, and they now hold less than 8% of UK CRE investments (around 5% of the total UK CRE market), limiting the impact they could have on the wider market.
A major structural change since the GFC has been growth in the importance of foreign investors, whose share of the total UK CRE stock has increased markedly (Chart C). The appetite of foreign investors for UK assets will be influenced by a number of factors, including the strength of their domestic market and the exchange rate. Foreign investors might be more likely to react sharply to a market stress in UK CRE and retrench, which could amplify potential risks related to leveraged investors and open-ended funds.